What is a real interest rate?
A real interest rate is an interest rate that has been adjusted to remove the effects of inflation to reflect the real cost of funds to the borrower and the real return to the lender or to an investor. The real interest rate reflects the rate of time preference of current goods over future goods. The real interest rate of an investment is calculated as the difference between the nominal interest rate and the inflation rate:
Real interest rate = Nominal interest rate – Inflation (expected or actual)
Key points to remember
- The real interest rate adjusts the observed interest rate in the market for the effects of inflation.
- The real interest rate reflects the purchasing power value of interest paid on an investment or loan and represents the time preference rate of the borrower and the lender.
- Since inflation rates are not constant, potential real interest rates should be based on estimates of expected future inflation over the term to maturity of a loan or loan. investment.
Interest rates: nominal and real
Understanding the real interest rate
While the nominal interest rate is the rate of interest actually paid on a loan or investment, the real interest rate reflects the change in purchasing power derived from an investment or abandoned by the borrower. The nominal interest rate is generally that announced by the institution guaranteeing the loan or investment. Adjusting the nominal interest rate to offset the effects of inflation makes it possible to identify changes in the purchasing power of a given level of capital over time.
According to the interest time preference theory, the real interest rate reflects the degree to which an individual prefers present goods to future goods. A borrower willing to take advantage of the current use of funds shows a stronger time preference for current assets over future assets and is willing to pay a higher interest rate for the funds loaned. Likewise, a lender who strongly prefers to postpone consumption into the future shows less time preference and will be willing to lend funds at a lower rate. Adjusting for inflation can help reveal the rate of time preference among market participants.
Expected inflation rate
The expected inflation rate is communicated by the US Federal Reserve to Congress on a regular basis and includes estimates for a minimum period of three years. Most anticipated interest rates are presented as ranges rather than point estimates. Since the real inflation rate may not be known until the period corresponding to the investment holding period has elapsed, the associated real interest rates should be considered as predictive or anticipated in nature, when the rates apply to periods which have yet to pass.
Effect of inflation rates on the purchasing power of investment earnings
In cases where inflation is positive, the real interest rate is lower than the advertised nominal interest rate.
For example, if the funds used to purchase a certificate of deposit (CD) are set at 4% interest per annum and the inflation rate for the same period is 3% per annum, the actual interest rate levied on the investment is 4% – 3% = 1%. The real value of funds deposited in the CD will only increase by 1% per year, when purchasing power is taken into consideration.
If these funds were instead placed in a savings account with an interest rate of 1% and the inflation rate remained at 3%, the real value, or purchasing power, of savings funds would have actually decreased, since real interest would be -2%, after accounting for inflation.